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The 4 critical topics in speculation & investment - Outside View by Rick Rule

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The 4 critical topics in speculation & investment
Jan 5, 2013

Most market decisions involve "probabilities," events that are more likely than not to occur; "possibilities," events that might, but are unlikely to occur; "whens," events that are certain to transpire, but we cannot determine the timing; and "if" events, where the outcome itself is uncertain.

Speculating on the "probable" and the "when" outcomes, is almost always more profitable than gambling on "possible," or "if" outcomes. "Possible" or "if" scenarios can still make good investments where potential risks and rewards are disproportionately in one's favor, but only when one can easily afford an unsuccessful outcome. By determining the spectrum of outcomes, ranging from the mere "possible" to the more "probable," an investor can position his or her portfolio to be more balanced and prepped to succeed despite the inherent uncertainties of the markets.

PROBABILITIES

Probabilities are events that are more likely than not to take place, based on consideration of the evidence. They are not "certainties," but forecasts. They are not absolutely reliable, but having a studied, carefully weighed opinion on what outcomes belong to this category can greatly improve one's competitive performance when most market participants do not even ask themselves the question.

In investments in natural resource our identification of probable outcomes gives us opportunity and our ability to act on them a decided advantage over other, less prepared market competitors. For example, resource and commodity markets are cyclical, capital intensive and volatile. These characteristics are often inconvenient and frequently unnerving, but also often broadly predictable, though not necessarily as to timing. Resource markets tend to work, and periods of low prices give way to periods of high prices, and vice versa. This is cyclicality.

During periods of low prices, like for natural gas or uranium today, these low prices stimulate demand and constrain supply. Demand goes up because the utility of the commodity to users increases, and conservation and substitution go down. In addition, the low prices encourage fabrication adaption and utilization. You can see this in U.S. natural gas markets right now, as plentiful gas supplies and bargain prices allow gas-fired heat to murder the competition from heating oil, encourage chemical and fertilizer utilization, facilitate conversion of electrical generation from oil and coal to gas, and even encourage the adaptation of natural gas as a motor fuel, in preference to gasoline and diesel.

Low prices thus stimulate demand, but also constrain supply. At today's prices, producers of natural gas in the U.S. and Canada today are often neither earning their cost of capital nor covering their operating costs. These producers are therefore unlikely to spend billions of dollars developing new supplies, and may shutter their projects entirely.

As consumers use up existing inventories, without any new production, the depletion in extractive industries rebalances the natural gas markets. This process takes time, because producers will continue to produce gas in low price environments to attempt to recover the capital invested in productive capacity, often producing assets down to or below their cash costs of production.

As supply bottoms and demand continues to grow, prices will have to rise. When prices begin to turn, the markets often overshoot what one might describe as a pricing equilibrium. The utility derived from cheap gas results in a multiplicity of users and demand types, and markets lag in their reaction to higher prices, though of course they eventually catch up. Rising prices do not stimulate supply easily or rapidly either, as producers might not trust early pricing signals, or may lack the financial or physical capabilities to produce more gas to take advantage of a resurgent market. These structural lags in the supply and demand functions exist in nearly every market, but because of the capital intensive nature of the commodities business, they are especially pronounced in the natural resource industry.

Over time, (remember the middle of the last decade) the high prices of natural gas will discourage demand through conservation and substitution, and encourage supply, through investment and new technology. And so the cycle will begin anew. Low prices beget high prices, and high prices beget low prices.

Thus, periods of high prices become increasingly highly probable as a direct consequence of periods of low prices. In financial parlance, a "bull market" is a probable consequence of a "bear market".

POSSIBILITIES

Drill hole speculation is the classic resource "possibility" speculation. The initial drill hole on a mineral or oil and gas prospect can add extraordinary value "IF" it is successful, which is unfortunately unusual. Not all drill holes are created equal, so some drill holes are more prospective than others. In particular, holes drilled subsequent to a discovery hole can add valuable information with much less risk than drilling a virgin prospect. The temptation associated with the initial drill is the "possibility" of the very short term ten-bagger potential for one return which can reward the lucky few who participate in an early discovery.

There is nothing wrong with the aggressive speculation involved in betting on possibilities if one can afford the risk. Those of us who participate in these activities successfully learn to study the data associated with the risk very carefully. In drill hole speculation, such factors as surface sampling, geochemical surveys, seismic data and geological mapping are all factors that a drill hole speculator may study in order to properly assess the risk he or she is assuming. It is critical, given the risks one assumes in "possibility" speculation, to only participate in outcomes that are likely to be extraordinarily lucrative if successful. In this "game" one's occasional successes must amortize many more numerous failures, so the rewards for success must be very substantial.

Given that failure is the expected outcome in "possibility" investing, the discipline to cut losses is a critical factor in a successful strategy. If the speculation involves betting on the successful outcome of a drill hole for example, if the hole is unsuccessful, your reason to own the stock has disappeared, and you should sell that stock and realize your loss before it grows. Hope is not a strategy. Your sporadic wins stand a better chance of amortizing your losses if you have the discipline to cut your losses.

It is also important to not assume too many correlated "possibility" bets. High political risk does not always correlate to high potential reward. The temptation to invest in this manner happens to me frequently when I assume outsized political risk. The nature of political risk is that crucially failing states often recover, while very wealthy societies usually deteriorate, but the timing and certainty of this observation is so tenuous that most extreme political risk bets are "possibilities" rather than probabilities.

A very successful "possibility" political risk bet I took occurred in 1999, during the horrific conflicts in the Democratic Republic of the Congo. This famously mineral-rich land was beset by a kleptocratic central government, wracked by a multi-party civil war, over-run by war lords and private brigands, and infested with malaria, AIDS, Ebola and cholera... it was not a happy place. But I knew that minerals do not deplete as a consequence of disease or stupidity, and I bet big on a couple of deposits at least nominally controlled by reputable outsiders. The best of these "bets" ran from $.30 to $19, as some sense of stability returned and mining equity markets improved But I could more easily have lost 100% of my investment. Making non-correlated political bets is more prudent, although having a "portfolio" of lousy countries is still a very high risk strategy!

WHEN

"When" events have a reasonably certainty of taking place, but are uncertain about the timing. Most speculators are so lazy, that they invest in "if" events as if they are "when" events, which makes holding speculative stocks, particularly in volatile markets, very traumatic for them. You should use this tendency to your advantage. An event that you believe is highly likely to occur, despite its questionable timing, can be a very good speculation.

During the uncertainties of 2008, two "when" circumstances took place which should illustrate this. We found a number of stocks selling at greater than 50% discounts to their cash in the treasury that also had reasonable management and other assets the market valued at zero. A recovery to cash values or near cash values was a very near certainty, but in those times fear was so rampant that most speculators were unwilling to take the time risk. Mercifully we were not, and we reaped a handsome reward. At the same time, some of the very finest "infrastructure income stocks" (pipelines, port facilities, terminals etc.) sold off to the point where highly reliable multiyear income streams were discounted to 15% and greater yields. It appeared certain that these stable income streams would eventually survive any market, as reliable income is always in demand, but investors were so traumatized that these "when" investments went begging for about six months!

I look at the debasement of the U.S. dollar (and perhaps all fiat currencies) as a "when" event. In fact, I suspect it has already started. Inflation as reported in the CPI is certainly tame, but they don't shop where I do! Look at the escalation in commodities prices, even in the face of a very soft economy. The pricing numerator is less important, when the denominator is falling steadily.

Maybe I'm wrong about the timing, but it is unlikely that many of us would bet against this being a 'when," rather than an "if" scenario.

IF

"If" scenarios are the most dangerous of the speculative scenarios, because they revolve around hope, as opposed to considered probabilities or possibilities. An "if" speculation is most often merely a rationalization, an excuse to continue to hold a stock whose failure should be evident. A drill hole speculation where the thesis was disproved rather than proved is a classic example. Many speculators refuse to accept their mistakes, saying "maybe they will have better luck with their next attempt," a fine thought, if combined with a knowledge of geology and careful consideration. But most "if" speculators often lack both geological knowledge and have not given the matter careful consideration. They need to remember that companies seldom drill their worst ideas first.

Several of my colleagues in the investment industry are making "if" statements about the U.S. economy and dollar too, in my opinion. IF we can achieve bipartisan commitment (commitment to what?), IF we can solve the fiscal cliff (solving our debt problem by going deeper in debt), IF we can grow our way out of our debt...

So there are four critical topics in speculation and investment. It is important to categorize your decisions with the "probability, possibility, when and if" filter, and consider your actions in this context. This will temper your expectations and, importantly, exposure to undue risk.

I hope also that you like this speech enough to utilize it and our other educational material, which you can access by going to the Investment University page on the Sprott Global website.

Thank you for reading.
Rick Rule

This article is authored by Rick Rule, Chairman of Sprott US Holdings.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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